Commodities Upleg Cycles

Thanks to their powerful decade-old secular bull, commodities are growing
increasingly popular among investors and speculators. Naturally the prudent
ones are always looking for insights to optimize their timing in buying low
and selling high. Knowledge of this bull's upleg and correction cycles helps
define probability bands for future trade timing.

Measuring commodities as a group is far more problematic than measuring stocks.
Individual commodities' fundamentals are generally much more divergent than
individual stocks'. Surprise factors driving material individual-commodity
price movements often have little impact on other commodities. Geopolitical
turmoil in the Middle East instantly moves crude oil, but the domestic natural-gas
market totally ignores it. An Australian drought affects wheat prices globally,
but doesn't move orange juice.

This is very different from the stock markets, where surprise economic data
often changes the outlook for (and hence pricing of) stocks in all sectors
simultaneously. A bad jobs report drives the entire stock markets, and the
vast majority of individual stocks, lower. This makes stock indexes more representative
of their underlying companies than commodities indexes of their component materials.

Due to their divergent drivers, analysis of individual commodities will
always remain the core of trade timing. If you are interested in trading oil
or oil stocks, you have to carefully monitor the technical, sentimental, and
fundamental scenes in that particular commodity. But this doesn't mean there
is no value in considering commodities as a group.

The more capital that flows into these raw materials, the more true this becomes.
Commodities have grown into a popular "risk trade" globally. This means traders
flood into raw materials as a group when optimism reigns, and quickly
exit them as a group when pessimism flares. Since the state of the stock markets
is the primary driver of universal sentiment, commodities have become very
highly correlated with the flagship S&P 500 stock index. This commodities
risk trade is critical for all traders to understand.

With big funds increasingly viewing and trading commodities as a homogenous
whole, the correlations of individual commodities' price action is gradually
rising. And this makes considering commodities as a group increasingly valuable
for traders. The premier index for following commodities as a group is not
today's CRB index as the financial media assumes, but the Continuous Commodity
Index (CCI).

Launched in 1957, the CRB has a venerable and proud history. Periodically
it was revised to reflect changing economic realities, with commodities fading
in importance removed. The original version included hides and lard, which
are certainly no longer relevant today. By 1995 this index had been revised
nine times, but the underlying calculation methodology remained the same. All
component commodities were equally-weighted and geometrically-averaged,
to smooth out price volatility.

But in July 2005, the CRB's entire history was cast aside for its controversial tenth
revision. Equal weighting was thrown out in an attempt to reflect the
economic importance of individual materials. Thus oil soared from 5.9% of
the classic CRB to 23.0% of the new CRB. Total petroleum products ballooned
from about 1/8th of the classic to 1/3rd of today's. This tenth revision
not only changed weightings, but calculation methodologies. So now the CRB
is an oil index totally unrelated to a half-century of history!

Thankfully the classic equally-weighted geometrically-averaged 17-component
CRB lives on in the form of the CCI. The CCI is simply the superior ninth-revision
CRB before Thomson Reuters/Jefferies bastardized and adulterated it. The new
CRB is simply too dominated by oil to reflect commodities as a whole, as I
have shown extensively.
So the CCI is now the flagship commodities index, and as more traders
understand why the CRB's popularity is gradually fading.

My chart this week looks at all the major uplegs and corrections of this entire
secular commodities bull, rendered through the lens of the CCI. Considering
these past upleg-correction cycles gives investors and speculators all kinds
of valuable insights into what kind of behavior is probable in future
uplegs and corrections. And ultimately since the future is unknown, trading
decisions simply game probabilities.

Commodities' performance during this past decade's secular bull has been mind-boggling.
The CCI stealthily bottomed way back in October 2001, when Wall Street ridiculed
the brave contrarians then buying deeply-out-of-favor commodities like gold.
But nearly 10 years later at its latest all-time high in April 2011, the CCI
had powered 276.1% higher! Commodities investors and speculators, including
our subscribers, have made fortunes.

And while this performance is outstanding absolutely, it is even more impressive
relatively. The S&P 500 stock index is universally considered the benchmark from
which all performance is measured. Over this exact decade-long span, this major
stock index only advanced 23.3%. Commodities provided stellar performance an
order of magnitude greater than the stock markets! This was during a brutal secular
stock bear to boot, truly awesome.

In the early years before the vast pools of risk capital started chasing commodities,
the CCI's uptrend was remarkably consistent. Before mid-2007, there were a
half-dozen major uplegs and corrections. These uplegs averaged 23.7% gains
over 10.0 months each, while the subsequent corrections averaged 7.8% losses
over 1.7 months. And the variance between individual uplegs and corrections
was generally fairly moderate, with most clustering near mean levels.

Back in those early years as we traded commodities stocks to huge realized
profits, I researched using
the CCI (then classic CRB) as a timing tool. But it wasn't representative enough
of the individual commodities produced by the companies we were trading including
gold, silver, copper, oil, and natural gas. So for years I rarely bothered
using the CCI as a secondary timing indicator. But that changed in late 2007.

For the first time in this entire secular bull to that point, commodities
really began to catch mainstream fund managers' attention in mid-2007.
As their huge capital flooded into these raw materials, commodities as a group
surged 44.7% in just under 7 months leading into early 2008! This was the CCI's
biggest upleg of this entire bull market, and it looked near-parabolic on the
charts. Naturally as commodities gained favor, the popular metals and energy
surged dramatically on this influx of capital.

Right after this massive upleg topped in March 2008, the sharpest normal correction
of this bull occurred. This was not unexpected given the outsized upleg before
it. The CCI plummeted 11.5% in just a half month on a gigantic 75-basis-point
rate cut by the Fed. Curiously this inflationary move that ought to have supported
commodities prices spooked futures traders, who sold aggressively. But indeed
commodities soon started surging again in another fast upleg ending a few months
later in July 2008.

Then the biggest market anomaly and discontinuity of our lives started unfolding,
the infamous 2008 stock panic. In July a bond panic started snowballing as
US mortgage giants Fannie Mae and Freddie Mac teetered on the edge of bankruptcy
following their stocks plummeting 72% and 78% in a single month!

Bond traders all over the world rushed to sell these GSEs' bonds to park their
capital safely in US dollars and US Treasuries. So a massive US dollar
rally was born. Ultimately the US Dollar Index blasted 22.6% higher in just
4 months, its biggest and fastest surge ever! Naturally this hammered
commodities, which are denominated in dollars.

Soon this bond panic morphed into the first true stock panic in
101 years. The S&P 500 plummeted 42.2% in just 3 months, an epic
bloodbath that sparked monumental fear. Traders were so terrified that they
rushed to dump everything regardless of fundamental merit. So commodities,
just discovered by big risk capital in the past year, were sold with reckless
abandon. The CCI plummeted a previously-unimaginable 46.7% in just over 5
months! Commodities prices were devastated.

But this was a sentimental selloff, a totally-irrational fear-based
panic. Underlying commodities fundamentals remained strong, global demand for
these scarce raw materials was still growing at faster rates than their supplies.
So prices had to be bid back up as soon as that hellstorm of fear passed, as
I argued at the time. Indeed we advised our subscribers to aggressively buy
commodities stocks in that panic's wake, a hugely-contrarian bet that proved
wildly profitable.

Since the CCI's panic bottom in December 2008, it has powered 110.7% higher
to major new all-time highs in April 2011. Not surprisingly, this post-panic
recovery happened a lot faster than the early years of this secular commodities
bull. Not only were commodities prices driven to ludicrously-oversold levels
during the panic, but speculators, investors, and fund managers remained very
attracted to raw materials after that once-in-a-lifetime anomaly. So capital
was quick to return.

Since the panic, the CCI's half-dozen uplegs have averaged gains of 23.3%
over a 3.3-month duration. Its post-panic corrections (not including today's
since we don't know if it is finished yet) averaged 9.4% declines over 1.7
months. These numbers are very interesting, and not what I expected given the
steeper rise in the CCI after the panic compared to before it.

Average post-panic uplegs of 23.3% are nearly identical to the pre-panic era's
23.7%! For some reason commodities as a group generally don't rally
much more than this before a healthy correction emerges to rebalance sentiment.
So once any commodities upleg as measured by the CCI approaches 25% gains,
speculators need to be cautious. The odds for an imminent correction increase
dramatically then.

Despite similar pre-panic and post-panic upleg gains, the average upleg duration
has shrunk dramatically. Where pre-panic CCI uplegs averaged 10.0 months each,
the post-panic ones were only a third as long at 3.3 months each. Commodities
price action has been greatly condensed in this new world where risk capital
quickly sloshes into and out of raw materials when influenced by stock-market
sentiment.

Once again the post-panic corrections averaged losses of 9.4% each over 1.7
months. This compares very closely to the pre-panic averages of 7.8% also over
1.7 months. It is very intriguing how similar corrections are today despite
much faster uplegs leading into them. So when commodities as a group are correcting,
once the CCI loses 8% to 9% and 6 or 7 weeks have passed the odds balloon that
a new upleg is imminent.

If you average all the uplegs of this entire bull, their average gain is 24.8%
over 6.4 months. Every correction (except that brutally outsized and unrepeatable
panic plunge) averaged 8.8% losses over 1.6 months each. While these numbers
can't tell you exactly when a future upleg or correction will end, they can
certainly help define probability bands to help investors and speculators make
prudent decisions.

And really these upleg-correction cycles don't need to define precise
tops and bottoms, as individual commodities' technicals and sentiment are vastly
more adept at that. But as a secondary tool to help confirm likely tops
or bottoms, knowledge of these general-commodities upleg-correction cycles
is extremely valuable. The more floodlights illuminating price action from
different angles, the better traders can understand and react to it.

These probability bands based on a decade of major uplegs and corrections
in the CCI are easy to understand and use. When a CCI upleg approaches 25%
gains, odds are it is getting mature. If other individual commodities' technical
indicators concur, speculators should lighten up their positions, realize profits,
and prepare for another correction. While uplegs can grow larger, most
of the time they don't.

Conversely after a 9% correction in this definitive commodities index, probabilities
really start favoring a new upleg being born. If individual commodities' technical
indicators also show oversold readings, speculators and investors alike should
aggressively buy new positions ahead of the next upleg. With the exception
of that anomalous stock panic, around 11% is about as big as CCI corrections
ever get. Also note that CCI corrections usually end near its black 200dma
line, so watch for that as well.

Why are these corrections relatively small? I suspect the CCI's equal weighting
among its 17 components and geometric averaging of their prices is a major
factor. And other than stock-market-sentiment-spawned risk-on and risk-off
biases, individual commodities' fundamentals still don't often line up. Factors
that drive wheat prices generally don't affect gold prices or oil prices. So
a big correction in any one component or group of them generally isn't universal
across all 17 commodities. This along with this index's inherent mathematical
smoothing makes CCI selloffs modest.

Provocatively, our current CCI correction hit 9.9% over 2.2 months in late
June. This implies, based on bull-to-date precedent, that this general-commodities
correction has largely run its course. This is one reason among many why we
just started a new commodities-stock deployment in our newsletters. Still in
its infancy, we expect to add many new trades in the coming months that ought
to prove very profitable by this winter or next spring.

At Zeal we started actively gaming commodities prices and trading commodities
stocks a decade ago when few others were doing it. All the experience
since generated priceless wisdom, knowledge, and instincts on this sector that
newer commodities-stock traders simply can't match. Our track record is stellar.
Since 2001, all 583 stock
trades recommended in our newsletters averaged annualized realized gains
of +52%! Can you imagine your capital growing 50% a year for a decade?

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The bottom line is general commodities upleg-correction cycles offer valuable
insights into timing trades. While this is a secondary indicator since individual
commodities have very different price drivers, it still helps define probability
bands. When the CCI has rallied high enough to hit its tight secular-bull-to-date
average gain, or corrected low enough to hit its average loss, odds are a major
trend change is imminent.

If individual commodities' indicators concur on being overbought after a CCI
upleg or oversold after a correction, speculators and investors should sell
or buy accordingly. And as more mainstream capital migrates into commodities,
the correlations of their individual price action will continue growing despite
divergent fundamentals. So CCI analysis should become more relevant and valuable
for trading.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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